Chapter 02 - The Nature of Costs
Chapter 2
The Nature of Costs
P 2-1:Solution to Darien Industries (CMA adapted) (10 minutes)
[Relevant costs and benefits]
Current cafeteria income
Sales$12,000
Variable costs (40% × 12,000)(4,800)
Fixed costs(4,700)
Operating income$2,500
Vending machine income
Sales (12,000 × 1.4)$16,800
Darien's share of sales
(.16 × $16,800)2,688
Increase in operating income$ 188
P 2-2:Negative Opportunity Costs (10 minutes)
[Opportunity cost]
Yes, when the most valuable alternative to a decision is a net cash outflow that would have occurred is now eliminated. The opportunity cost of that decision is negative (an opportunity benefit). For example, suppose you own a house with an in-ground swimming pool you no longer use or want. To dig up the pool and fill in the hole costs $3,000. You sell the house instead and the new owner wants the pool. By selling the house, you avoid removing the pool and you save $3,000. The decision to sell the house includes an opportunity benefit (a negative opportunity cost) of $3,000.
P 2-3:Solution to NPR (10 minutes)
[Opportunity cost of radio listeners]
The quoted passage ignores the opportunity cost of listeners’ having to forego normal programming for on-air pledges. While such fundraising campaigns may have a low out-of-pocket cost to NPR, if they were to consider the listeners’ opportunity cost, such campaigns may be quite costly.
P 2–4:Solution to Silky Smooth Lotions (15 minutes)
[Break even with multiple products]
Given that current production and sales are: 2,000, 4,000, and 1,000 cases of 4, 8, and 12 ounce bottles, construct of lotion bundle to consist of 2 cases of 4 ounce bottles, 4 cases of 8 ounce bottles, and 1 case of 12 ounce bottles. The following table calculates the breakeven number of lotion bundles to break even and hence the number of cases of each of the three products required to break even.
Per Case / 4 ounce / 8 ounce / 12 ounce / BundlePrice / $36.00 / $66.00 / $72.00
Variable cost / $13.00 / $24.50 / $27.00
Contribution margin / $23.00 / $41.50 / $45.00
Current production / 2000 / 4000 / 1000
Cases per bundle / 2 / 4 / 1
Contribution margin per bundle / $46.00 / $166.00 / $45.00 / $257.00
Fixed costs / $771,000
Number of bundles to break even / 3000
Number of cases to break even / 6000 / 12000 / 3000
P 2–5:Solution to J.P.MaxDepartment Stores (15 minutes)
[Opportunity cost of retail space]
Home Appliances / TelevisionsProfits after fixed cost allocations / $64,000 / $82,000
Allocated fixed costs / 7,000 / 8,400
Profits before fixed cost allocations / 71,000 / 90,400
Lease Payments / 72,000 / 86,400
Forgone Profits / – $1,000 / $ 4,000
We would rent out the Home Appliance department, as lease rental receipts are more than the profits in the Home Appliance Department. On the other hand, profits generated by the Television Department are more than the lease rentals if leased out, so we continue running the TV Department. However, neither is being charged inventory holding costs, which could easily change the decision.
Also, one should examine externalities. What kind of merchandise is being sold in the leased store and will this increase or decrease overall traffic and hence sales in the other departments?
P 2–6:Solution to Executive Stock Options (15 minutes)
[Opportunity cost of stock options]
The statement that there is “no cost to the company” is wrong. As soon as this stock option is granted, the number of shares having claims on the firm’s future cash flows increases by the expected likelihood that this option will be exercised. Existing shareholders’ claims on the future cash flows have been diluted. Thus, there is an opportunity cost imposed on the existing shareholders by issuing stock options to directors. They are not free. There is no cash outlay to the firm when stock options are issued; accounting earnings are not affected by issuing stock options (as long as they are issued at or above the current stock price), but there is a cost to the shareholders.
P 2-7:Solution to Bidwell Company (CMA adapted) (15 minutes)
[Simple break-even analysis]
a.Breakeven=
= = 70,000 units
b.[10Q – 7Q – 210,000](1 – .4) =90,000
(3Q – 210,000) (.6) =90,000
3Q =150,000 + 210,000
Q =120,000
c.Breakeven= = 80,500 units
P 2-8:Solution to Vintage Cellars (15 minutes)
[Average versus marginal cost]
a.The following tabulates total, marginal and average cost.
Quantity / Average Cost / Total Cost / Marginal Cost1 / $12,000 / $12,000
2 / 10,000 / 20,000 / $8,000
3 / 8,600 / 25,800 / 5,800
4 / 7,700 / 30,800 / 5,000
5 / 7,100 / 35,500 / 4,700
6 / 7,100 / 42,600 / 7,100
7 / 7,350 / 51,450 / 8,850
8 / 7,850 / 62,800 / 11,350
9 / 8,600 / 77,400 / 14,600
10 / 9,600 / 96,000 / 18,600
b.Marginal cost intersects average cost at minimum average cost (MC=AC=$7,100). Or, at between 5 and 6 units AC = MC = $7,100.
c.At four units, the opportunity cost of producing and selling one more unit is $4,700. At four units, total cost is $30,800. At five units, total cost rises to $35,500. The incremental cost (i.e., the opportunity cost) of producing the fifth unit is $4,700.
d.Vintage Cellars maximizes profits ($) by producing and selling seven units.
Quantity / Average Cost / TotalCost / Total
Revenue / Profit
1 / $12,000 / $12,000 / $9,000 / -$3,000
2 / 10,000 / 20,000 / 18,000 / -2,000
3 / 8,600 / 25,800 / 27,000 / 1,200
4 / 7,700 / 30,800 / 36,000 / 5,200
5 / 7,100 / 35,500 / 45,000 / 9,500
6 / 7,100 / 42,600 / 54,000 / 11,400
7 / 7,350 / 51,450 / 63,000 / 11,550
8 / 7,850 / 62,800 / 72,000 / 9,200
9 / 8,600 / 77,400 / 81,000 / 3,600
10 / 9,600 / 96,000 / 90,000 / -6,000
P 2-9:Solution to Sunnybrook Farms (CMA adapted) (15 minutes)
[Incremental costs and revenues of extending retail store hours]
Annual Sunday incremental costs$24,960
÷ 52 weeks
Weekly Sunday incremental costs$ 480
Sunday sales to cover incremental costs
480 ÷ (.2)$ 2,400
Sunday sales to cover lost sales during
the week 2,400 ÷ (1 – .6)$ 6,000
Check:
Sunday sales$ 6,000
Additional Sales due to Sunday
($6,000 × 40%)$ 2,400
Gross Margin on additional sales
($2,400 × 20%)$ 480
× 52 Weeks$24,960
P 2-10:Solution to Taylor Chemicals (15 minutes)
[Relation between average, marginal, and total cost]
a. Marginal cost is the cost of the next unit. So, producing two cases costs an additional $400, whereas to go from producing two cases to producing three cases costs an additional $325, and so forth. So, to compute the total cost of producing say five cases you sum the marginal costs of 1, 2, …, 5 cases and add the fixed costs ($500 + $400 + $325 + $275 + $325 + $1000 = $2825). The following table computes average and total cost given fixed cost and marginal cost.
Quantity / MarginalCost / Fixed
Cost / Total
Cost / Average
Cost
1 / $500 / $1000 / $1500 / $1500.00
2 / 400 / 1000 / 1900 / 950.00
3 / 325 / 1000 / 2225 / 741.67
4 / 275 / 1000 / 2500 / 625.00
5 / 325 / 1000 / 2825 / 565.00
6 / 400 / 1000 / 3225 / 537.50
7 / 500 / 1000 / 3725 / 532.14
8 / 625 / 1000 / 4350 / 543.75
9 / 775 / 1000 / 5125 / 569.44
10 / 950 / 1000 / 6075 / 607.50
b.Average cost is minimized when seven cases are produced. At seven cases, average cost is $532.14.
c.Marginal cost always intersects average cost at minimum average cost. If marginal cost is above average cost, average cost is increasing. Likewise, when marginal cost is below average cost, average cost is falling. When marginal cost equals average cost, average cost is neither rising nor falling. This only occurs when average cost is at its lowest level (or at its maximum).
P 2-11:Solution to Emrich Processing (15 minutes)
[Negative opportunity costs]
Opportunity costs are usually positive. In this case, opportunity costs are negative (opportunity benefits) because the firm can avoid disposal costs if they accept the rush job.
The original $1,000 price paid for GX-100 is a sunk cost. The opportunity cost of GX-100 is -$400. That is, Emrich will increase its cash flows by $400 by accepting the rush order because it will avoid having to dispose of the remaining GX-100 by paying Environ the $400 disposal fee.
How to price the special order is another question. Just because the $400 disposal fee was built into the previous job does not mean it is irrelevant in pricing this job. Clearly, one factor to consider in pricing this job is the reservation price of the customer proposing the rush order. The $400 disposal fee enters the pricing decision in the following way: Emrich should be prepared to pay up to $399 less any out-of-pocket costs to get this contract.
P 2–12:Solution to Gas Prices (15 minutes)
[“Price gouging” or increased opportunity cost?]
The opportunity cost of the oil in process was higher after the invasion and thus the oil companies were justified in raising prices as quickly as they did. For example, suppose the oil company had one barrel of oil purchased at $15. This barrel was refined and processed for another $5 of cost and then the refined products from the barrel sold for $21. Replacing that barrelrequires the oil company to pay another $15 per barrel on top of the $15 per barrel it is already paying. Therefore, in order to replace the old barrel, the prices of the refined products must be raised as soon as the crude oil price rises.
However, accounting treats the realized holding gain on the old oil as an accounting profit, not as an opportunity cost. Therefore, the income statement of oil companies with large stocks of in-process crude will show accounting profits, unless they can somehow defer these profits. Switching to income-decreasing accounting methods and writing off obsolete equipment will help the oil companies avoid the political embarrassment of reporting the holding gains. In January 1990, the large oil companies received significant adverse media publicity when they reported large increases in fourth-quarter profits.
It is useful having discussed this problem to ask the following question: What happens to oil companies in the reverse situation when a large, unexpected price drop occurs? Suppose the oil company purchased old barrels for $15 and sold the refined products for $21. New barrels now can be purchased for $10. The company would like to keep selling refined products at $21, but competition from other oil companies will push the price of refined products down. Depending on how quickly the price of refined products fall, the oil companies will report smaller (maybe even negative) accounting earnings as their inventory of $15 oil gets refined and sold, but at lower prices.
P 2–13:Solution to Penury Company (15 minutes)
[Break-even analysis with multiple products]
a.Breakeven when products have separate fixed costs:
Line K / Line LFixed costs / $40,000 / $20,000
Divided by contribution margin / $0.60 / $0.20
Breakeven in units / 66,667 units / 100,000 units
Times sales price / $1.20 / $0.80
Breakeven in sales revenue / $80,000 / $80,000
b.Cost sharing of facilities, functions, systems, and management. That is, the existence of economies of scope allows common resources to be shared. For example, a smaller purchasing department is required if K and L are produced in the same plant and share a single purchasing department than if they are produced separately with their own purchasing departments.
c.Breakeven when products have common fixed costs and are sold in bundles with equal proportions:
At breakeven we expect:
Contribution from K + Contribution from L = Fixed costs
$0.60 Q + $0.20 Q = $50,000
where Q = number of units sold of K = number of units sold of L
$0.80 Q= $50,000
Q=62,500 units
Break-even / Break-evenProduct
K
L / Units
62,500
62,500 / Price
$1.20
$0.80 / Sales
$75,000
$50,000
P 2-14:Solution to University Tuition Benefits (15 minutes)
[Opportunity cost of faculty and staff tuition benefits: tax incentives]
a.It does not “cost” the University of Pennsylvania $7 million to send employee children to Penn and other schools. By offering this benefit, Penn is able to employ higher quality staff and faculty at a lower cost than if this benefit were not offered. Because this benefit is not taxed, Penn is able to give its employees $1 of benefits (tuition) that would cost the employees $2 (before personal taxes) if they had to pay the tuition themselves (assuming a 50 percent tax rate). Thus, employees are willing to accept up to $2 of lower wages for each $1 of tuition benefit.
Also, if the employee’s child attends the parent’s institution, the cost to the institution is not the full amount of the tuition, if there is excess capacity in the classroom. However, given that all higher education is subsidized through either endowment or state aid, then the tuition does not cover the full cost of education. Adding 100 additional students each year, in the long run can cause the institution to forego admitting tuition paying students.
b.Probably not. Case Western will either have to increase wages or see a reduction in faculty and staff quality. These tuition benefits are tax free. As long as some of the tax benefits are shared between Case Western and its employees (not all the tax savings accrue to the employees), then Case Western is worse off by cutting the tuition benefit. Moreover, cutting its tuition benefit for employee children who attend its graduate schools increases the price of its programs to these students. At the margin, some students will switch to other graduate programs. As with all price increases, fewer students will attend Case Western, and those that do will be of lower quality.
P 2–15:Solution to Volume and Profits (15 minutes)
[Cost-volume-profit]
a.False.
b.Write the equation for firm profits:
Profits = P×Q - (FC - VC × Q) = Q(P - VC) - FC
= Q(P - VC) - (FC ÷ Q)Q
Notice that average fixed costs per unit (FC÷Q) falls as Q increases, but with more volume, you have more fixed cost per unit such that (FC÷Q) × Q = FC. That is, the decline in average fixed cost per unit is exactly offset by having more units.
Profits will increase with volume even if the firm has no fixed costs, as long as price is greater than variable costs. Suppose price is $3 and variable cost is $1. If there are no fixed costs, profits increase $2 for every unit produced. Now suppose fixed cost is $50. Volume increases from 100 units to 101 units. Profits increase from $150 ($2 ×100 - $50) to $152 ($2 × 101 - $50). The change in profits ($2) is the contribution margin. It is true that average unit cost declines from $1.50 ([100 × $1 + $50]÷100) to $1.495 ([101 × $1 + $50]÷101). However, this has nothing to do with the increase in profits. The increase in profits is due solely to the fact that the contribution margin is positive.
Alternatively, suppose price is $3, variable cost is $3, and fixed cost is $50. Contribution margin in this case is zero. Doubling output from 100 to 200 causes average cost to fall from $3.50 ([100 × $3 + $50]÷100) to $3.25 ([200 × $3 + $50]÷200), but profits are still zero.
P 2-16:Solution to American Cinema (20 minutes)
[Breakeven analysis for an operating decision]
a.Both movies are expected to have the same ticket sales in weeks one and two, and lower sales in weeks three and four.
Let Q1 be the number of tickets sold in the first two weeks, and Q2 be the number of tickets sold in weeks three and four. Then, profits in the first two weeks, 1, and in weeks three and four, 2, are:
1 = .1(6.5Q1) – $2,000
2 = .2(6.5Q2) – $2,000
“I Do” should replace “Paris” if
12, or
.65Q1 – 2,000 > 1.3Q2 – 2,000, or
Q1 > 2Q2.
In other words, they should keep “Paris” for four weeks unless they expect ticket sales in weeks one and two of “I Do” to be twice the expected ticket sales in weeks three and four of “Paris.”
b.Taxes of 30 percent do not affect the answer in part (a).
c.With average concession profits of $2 per ticket sold,
1 = .65Q1 + 2Q1 – 2,000
2 = 1.30Q2 + 2Q2 – 2,000
12 if
2.65Q1 > 3.3Q2
Q1 > 1.245Q2
Now, ticket sales in the first two weeks need only be about 25 percent higher than in weeks three and four to replace “Paris” with “I Do.”
P 2-17:Solution to Home Auto Parts (20 minutes)
[Opportunity cost of retail display space]
a.The question involves computing the opportunity cost of the special promotions being considered. If the car wax is substituted, what is the forgone profit from the dropped promotion? And which special promotion is dropped? Answering this question involves calculating the contribution of each planned promotion. The opportunity cost of dropping a planned promotion is its forgone contribution: (retail price less unit cost) × volume. The table below calculates the expected contribution of each of the three planned promotions.
Planned Promotion DisplaysFor Next Week
End-of-
Aisle / Front
Door / Cash
Register
Item / Texcan Oil / Wiper blades / Floor mats
Projected volume (week) / 5,000 / 200 / 70
Sales price / 69¢/can / $9.99 / $22.99
Unit cost / 62¢ / $7.99 / $17.49
Contribution margin / 7¢ / $2.00 / $5.50
Contribution
(margin × volume) / $350 / $400 / $385
Texcan oil is the promotion yielding the lowest contribution and therefore is the one Armadillo must beat out. The contribution of Armadillo car wax is:
Selling price$2.90
less: Unit cost$2.50
Contribution margin$0.40
× expected volume 800
Contribution$ 320
Clearly, since the Armadillo car wax yields a lower contribution margin than all three of the existing planned promotions, management should not change their planned promotions and should reject the Armadillo offer.
b.With 50 free units of car wax, Armadillo’s contribution is:
Contribution from 50 free units (50 × $2.90)$145
Contribution from remaining 750 units:
Selling price$2.90
less: Unit cost$2.50
Contribution margin$0.40
× expected volume 750 300
Contribution$445
With 50 free units of car wax, it is now profitable to replace the oil display area with the car wax. The opportunity cost of replacing the oil display is its forgone contribution ($350), whereas the benefits provided by the car wax are $445.
Additional discussion points raised
(i)This problem introduces the concept of the opportunity cost of retail shelf space. With the proliferation of consumer products, supermarkets’ valuable scarce commodity is shelf space. Consumers often learn about a product for the first time by seeing it on the grocery shelf. To induce the store to stock an item, food companies often give the store a number of free cases. Such a giveaway compensates the store for allocating scarce shelf space to the item.
(ii)This problem also illustrates that retail stores track contribution margins and volumes very closely in deciding which items to stock and where to display them.
(iii)One of the simplifying assumptions made early in the problem was that the sale of the special display items did not affect the unit sales of competitive items in the store. Suppose that some of the Texcan oil sales came at the expense of other oil sales in the store. Discuss how this would alter the analysis.
P 2–18:Solution to Measer (20 minutes)
[Average versus variable cost]
"Beware of unit costs." If you focus solely on the unit cost numbers in the problem, you are likely to be misled.
In the long run, the firm should shut down because it cannot cover fixed costs. However, if the firm has already incurred or is liable for fixed factory and administration costs, then it should continue to operate if it can cover variable costs. Notice the assumption regarding timing. Fixed costs are assumed to have been incurred whereas variable costs are assumed not to have been incurred yet. Given these assumptions, the loss-minimizing rate of output is 11 million units:
Rate of Production and Sale (000's units)10,000 / 11,000 / 12,000 / 13,000
Sales @ $4.50/unit / $45,000 / $49,500 / $54,000 / $58,500
Total Costs / 58,000 / 62,400 / 67,000 / 71,600
Profit (Loss) / ($13,000) / ($12,900) / ($13,000) / ($13,100)
Notice, minimizing average unit costs is not the basis for choosing output levels. Average unit costs are minimized at 13 million units.
An alternative way to solve the problem is to calculate contribution margin, as below: